Real Estate Bubble – Part 4

Are housing prices in the final blow off stage? Talk of the housing bubble is in at least its third year. Yet, home prices still rise at rapid rates in many areas. The recent drop in interest mortgage rates is likely to support current price levels and even higher home prices. A possible new warning sign: CNBC now is covering real estate the way it used to cover technology stocks.

When the bubble talk first became widespread, I criticized it in these pages. Home prices can continue to rise as long as incomes increase enough to keep homes affordable, I wrote. In addition, home prices cannot have a bubble and crash the way technology stocks did. Most people live in their houses and generally sell only when they want to move. Finally, real estate is not a national market. Each area has its own housing market. Some markets have overvalued homes; others do not.

Since I reached those conclusions in October 2002, housing prices in a number of areas have increased dramatically. The increases even drew recent expressions of concern from Alan Greenspan and the Federal Reserve. The media is paying attention, including front page coverage in USA Today, Business Week, and other media. Let’s take a fresh look at the data, anecdotes, and our conclusions.

One of the more comprehensive reports is from the Federal Deposit Insurance Corporation (FDIC). The FDIC insures banks. Banks write a lot of mortgages, so the FDIC has an interest in knowing if home prices are at risk of collapsing.

The number of local markets the FDIC defines as in real estate booms grew by almost two thirds in 2004. A boom is defined as a total inflation-adjusted price gain of 30% or more over the last three years. The FDIC found there now are 55 out of 362 metropolitan areas experiencing real estate booms. The booms, of course, are located primarily in California, Florida, and the northeast. Very few boom areas are not near or on one of the coasts or in resort areas.

The FDIC study also concluded that this cluster of booms is different from past real estate booms. It believes that the high number of simultaneous boom markets is due to national factors instead of local conditions. The study cites easy credit, low interest rates, and the structure of mortgages as likely causes. Adjustable-rate and interest- only mortgages are structures that especially encourage buyers to pay more for homes.

Another sign of higher risk in housing is the rise in investment purchases. Several data sources indicate that a higher percentage of buyers than usual are buying residences as investments or second homes. Such buyers tend to sell quickly after prices peak, exacerbating the post-boom correction.

The ratio between house prices and rents is another caution flag. A study by the American Enterprise Institute found that the ratio of average yearly rents to house prices nationwide fell to 3.5% at the end of 2004. It was around 5% through the 1990s. Clearly, many buyers of real estate are counting on future appreciation and not rental income to justify their purchases. As in the late stock market boom, they are paying higher valuations than in the past.

That creates the potential for this worrisome scenario. Interest rates rise sharply. The number of people interested in buying homes and the prices they are willing to pay fall sharply. The higher mortgage rates also put pressure on owners with interest-only and adjustable-rate mortgages to sell if they cannot refinance. Soon, there are many more sellers than buyers, and home prices decline. This causes sales by those who bought to speculate on higher prices. The number of sellers increases, and the cycle feeds on itself to continue pushing down prices.

I still consider such a scenario very unlikely.

While I have anticipated higher long-term interest rates, I do not foresee rates rising so high that houses become unaffordable for most buyers. Higher rates would squeeze out marginal buyers and cause buyers to stop bidding up home prices. But that stops short of a bubble bursting. We also do not have another important element of a bubble about to burst: oversupply.

However the bubble debate ends, I do not believe that the recent rate of price increases can continue in most areas much longer. The most likely scenario is that home prices in most of the hot areas soon will begin a period of flat prices to moderate price increases.

The real test will be in two to five years when those interest-only and adjustable-rate mortgages start to need refinancing. The level of interest rates and the job market will determine if current price levels are sustainable or if a large number of homes get dumped on the market.

Whatever the national trends, each local market has to be considered on its own merits. Not every home is a good buy, and there probably is too much capital flowing into at least some areas and some types of housing. Condos and townhouses in many areas are the most sensitive to price changes. Second home communities also have highly volatile prices. But there are other areas in which building restrictions, the lack of undeveloped land, healthy economies, and an influx of new residents and buyers provide strong props for current price action. Remember, there is less likely to be a solid floor for prices in second home and resort areas and for condos and town home prices. Investors and speculators often bail out at the first sign of softness in prices. Communities of single-family homes with strong economies are much less vulnerable.

Instead of relying on anecdotes and national data, use the test I have given in past visits. Estimate the annual rental income a home could generate. Subtract insurance and property taxes. Divide that net amount into the anticipated price of the property. The result is the capitalization rate, or cap rate. If the cap rate is less than 5%, it is an overheated market. It probably is cheaper to rent than to buy. A cap rate over 10% is a bargain market.  From 5% to 10% is the normal, reasonably-priced range.

Don’t expect to get rich quickly by buying homes today. Despite the anecdotes, over the long term real estate prices nationally appreciate at about 1% above GDP.

Don’t let talk of a housing bubble deter you from buying a first or second home you want for the long term. But don’t let talk of recent appreciation draw you into the market. To review my past assessments of the housing bubble, see the Housing Watch section of the Archive on the web site.